Leaving money on the table in the economy - Free Essay Example

The firms leave money on the table by setting the offering price low is mostly explained by asymmetric information which is derived from several rational theories. Loughran, Ritter, Rydquist (1994) provide an international argument that underpricing may be caused by basic problems derived from microeconomic uncertainty and information asymmetry. Baron Holmstrom (1980) also pointed out that indeed there exists information asymmetry between underwriters and issuers, because the underwriters always have superior information to the issuers, which shows that underpricing is necessary for solving this moral hazard. Alternatively, Muscarella Vetsuypens (1989) find that there is no asymmetric information between issuer and investment banker, which is opposite to Barons (1982) model that the investment bankers have superior information about the capital market. Allen and Faulhaber (1989), Grinblatt Hwang (1989) and Welch (1989) claim it cannot be ignored that there is information asymmetry between issuers and investors, with issuers having more information. Another famous argument was asserted by Rock in 1986, he found that the asymmetric information also exists between informed and uniformed investors, and underpricing is essential to induce uninformed investors to participate in IPO offerings in the face of informed investors adverse-selection, which is described in Winners Curse Hypothesis specifically. In Rocks hypothesis, he established a model on the basis of Grossmans and Stiglitzs (1980) Paradox, and supposed the issue price of IPOs is impossible to be forecasted by issuers. The amoun t of information investors possess is the criteria for him to differentiate. Informed investors have access to superior information about the firm and holding the better position to make a decision that whether or not a new offering is worth an effort, however, uniformed investors know exclusively the probability distribution of a firms value. Thereby the underpriced new offerings are expected because only informed investors will submit purchase orders. By contrast, uninformed investors have a greater chance of collecting overpriced offering and a smaller change of receiving underpriced offering by the reason that they will submit orders randomly. Consequently, in order to attractive uniformed investors subscription and offset their loss for trading against superior information, offerings must be underpriced. Beatty Ritter (1986) also show that underpricing is demanded when uninformed investors become informed about individual firms prospects by investing in information, or else fa ce a winners curse. Similarly, Parson Raviv (1985) present that the discount is a result of information asymmetry among investors, and the explanation that how both seasoned and unseasoned issues are underpriced on average. 2.2 Underwriters reputation Some investigators prefer to focus on the explanation of IPO underpricing by underwriters reputation and argue that it will price IPOs closer to the intrinsic value to keep the reputation by the better established underwriters. Schultz Zaman (1994) pointed out another important argument that they believed the motivation for underwriters to support IPO trading prices because of the concern of underwriters reputation, which means that it will increase the confidence of investors (especially uniformed investors) if underwriters buy back the IPOs that have underperformed. Ruud (1993), Hanley (1993) and Schultz Zaman (1994) evidenced empirically that there is price support for IPOs from their underwriters; Xu Wu (2002) were also in support of that statement on Chinese stock market. Empirical tests measured by Hanley (1993), and he confirms that underpricing is positively related to revisions in the offering price that occur between the filing of the preliminary prospectus and the off er date. The level of underpricing depends on the underwriters final revision of the offer price. From an interesting perspective which finds a positive relationship between the presence of prestigious underwriter representatives on a firms board and the size of that firms equity offering. Benveniste Wilhelm (1997) and Sherman Titman (2002) also indicate that underwriter discretion can be used to the benefit of issuing firms. Moreover, according to Beattys Ritters (1986) study, which notices that underwriters who deviate from the expected behavior lose market share, and they claimed that underwriters, in order to avoid being punished later by either issuing firms if firms underpriced too much or investors if investors underpriced too little, they prefer to lower the offering price when they are dealing with the more speculative offerings. Similar results are reported by McDonald Fisher (1972), Logue (1973), Block Stanley (1980), and Johnson Miller (1988), they all find that short-term excess returns are smaller when new offerings are taken by prestigious underwriters. Loughran Ritter (2002) propose an agency explanation that since underwriters have complete discretion to allocate shares, they have an incentive to lower the offering price to provide gains to preferred buy-side clients and then benefit from the quid pro quos received from them. Empirically, Beatty Ritter (1986), Carter Manaster (1990), and Michael Shaw (1994) all support that the reputation of underwriters is related to the degree of underpricing negatively. Carter et al. (1998) examined categorical as well as the continuous definitions of reputation and concludes that both measurements are inversely related to underpricing, with the former proxy performing better in explaining initial returns. Even though the fact that the effect of underwriters on IPO underpricing has been confirmed in plentiful IPO studies, investigations by Allen Faulhaber (1989), Grinblatt Hwang (1989) and Welch (1989) state that the investment banker plays no active role in an IPO except as being the rationing administrator. They assume that the most superior information about a new firms prospects is obtained by the firm itself. The IPOs is sold at a discount price serves as a credible signal that it is a good firm and only a good firm can compensate the initial loss after its performance is recognized. In addition, Tian Zhan (2000) also objected to that theory strongly, they tested the relationship between underwriters reputation and underpriced IPOs in Chinese A-share market as well, and concluded that the reputation of underwriters cannot demonstrate Chinese IPOs underpricing because the Chinese government plays a crucial role in pricing IPOs rather than underwriters. 2.3 Signaling hypothesis With respect to the asymmetric information among issuers, investors and underwriters, signaling theory continues to be a significant component of underpriced IPOs research. According to early studies, such as Grinblatt Hwang (1989), assert that the issuing price of IPOs and the proportion of the remaining shares of initial shareholders are the intrinsic value of the issuing firms due to that these two signals represent mean and variance of the future cash flows. Welch (1989) argues that IPOs underpricing is caused by that the overvalued shares may be issued by firms in the future. Good issuers usually expect to be rewarded at seasoned equity offerings (SEOs) with sending a signal of their high quality to investors by underpricing their IPOs and keeping certain shares of IPOs for themselves. The empirical evidence is displayed by a critical test of the signaling hypothesis with separating equilibrium which is concentrated on the correlation between IPO underpricing and seasoned equ ity offerings. Allen Faulhaber (1989), Grinblatt Hwang (1989), and Welch (1989) suggest a signaling model in which IPO underpricing is an equilibrium outcome when issuers possess superior information associated with investors. If the revelation possibility for the issuers quality is neither too large nor too small, a separating equilibrium will occur where high-value issuers signal their quality by retaining a portion of shares and underpricing initial offerings, but low-value issuers sell all of their shares and do not underpricing. Ultimately, their results prove that IPOs underpricing is deliberate and voluntary, which purposes to signal a firms true value and attempts to achieve better prices in subsequent SEOs. At a mention of the empirical results that obtained by Su Fleisher (1999), they test the models by using early Chinese IPO data and investigate whether or not there exists an optimal signaling schedule relative to a firms intrinsic value and the degree of underpricing of initial offerings, which consistent with the signaling explanations intensively. While, Jegadeesh, Weinstein, Welch (1993) discover weak evidence that firms which underprice their IPOs are likely to issue seasoned equities and on average have larger SEOs by using US data. Furthermore, In Garfinkels (1993) test, he doesnt find the correlation by examining the probability of owner-managers (insiders) selling as a function of IPO underpricing, which leads to his doubt on signaling models. Then Su Fleisher (1999) outline their finding that IPO underpricing is negatively related to IPO size on total shares, which is interpreted by using issuers signaling of its intrinsic value and prospective objective to issue SEOs. 2.4 Lockup hypothesis The lockup is an agreement between the underwriter and the issuer prohibiting the sale of shares by insiders for a period of time after an IPO, and the average lockup period lasts six months (Aggarwal, Krigman, Womack, 2002). A mass of researchers find that in the Chinese IPO market the time elapsed between prospectus and list is always longer than that in developed markets. Su Fleisher (1999) consent to that viewpoint and claim a further suggestion that there exists a positive coefficient between the listing time lags and IPO underpricing, the result is based on their sample of 308 IPOs. Mok Hui (1998) also find a positive relationship between IPO underpricing and the time gap between issuing and listing a new issue in their sample of Shanghai firms, in their reason they explain that the longer time will promote risk and thereby the larger underpricing is needed because of asymmetric information among the issuers, investors and underwriters. The empirical evidence from Chen et al. (2004), on the basis of using the data from 1992 to 1997, they discover that for the total data, the average underpricing is 298%, but, for the data with duration less than 2 months, the average underpricing is 110%; while for duration greater than 2 months, the average underpricing is 631%. Their findings demonstrate the relationship between duration time and IPO underpricing is significant and positive. The similar results are also gained by Lee et al. (1996). Particularly, Chan et al. (2004), Chen et al. (2004), and Mok Hui (1998) suggest this phenomenon exists in the Chinese IPO market as well. In the additional study of Guo Brooks (2008), they also argue that there is a strong coefficient between the level of IPO underpricing and listing time lags. Diversely, a huge portion of observations on the impact of the lockup period involving signals of firm quality, such as organizational uncertainty. When the concentration of uncertainty on an organization is high, greater underpricing will be expected to be a result (Grinblatt and Hwang, 1989; Welch, 1989). Diamond Verrecchia (1991) explain that, when the higher concentration of ex ante uncertainty on a venture exists, there will be greater difficulties for potential investors to pricing the shares, and the distribution of their expected returns should be broad. Thus, we should expect higher underpricing for those ventures with a going concern shares. However, Arthurs et al., (2009) believe that, by utilizing a longer lockup period, entrepreneurs may be able to decrease investors uncertainty about the venture normally and hence may be able to decline the amount of underpricing. Certo et al., (2001) indicate this reduction in underpricing, is a benefit to the venture because it represents a promotion in the wealth that is appropriated by the venture. As this section is interested in inspecting whether or not the lockup period influence the IPOs prices, inducing that the interaction between the exist ence of this higher uncertainty, the length of the lockup period and the subsequent impact on the level of underpricing has to be focused on. 2.5 Financial regulations Allen (2001) indicates that financial theories have to be in terms of the fluency of financial institutions that dominate regulatory framework. Although the Chinese IPOs are not issued in a competitive market, they are arranged by an administrative project. As the Chinese government emphasized reforms of state-owned enterprises (SOEs) as its priority, it stresses two purposes that: first, to restructure the ownership and create a sound corporate governance system for mitigating the non-performing loans problem caused by SOEs; and, to promote SOE productivity and efficiency. State Economic Reform Commission regulars SOES in 1994 that, are needed to follow the requirements of a market economic system and establish a new enterprise system with clarified property rights, designated authorities and responsibilities, separated government and enterprise functions, and established scientific management. Generally, most researchers make an attempt to explore the underpricing of IPOs i n Chinese stock market based on observing market situations, nevertheless since the vast majority of IPOs in China are private-owned partially, the Chinese state becomes the real issuer of IPOs and benefits itself of no longer funding these firms directly (Chi Padgett, 2005). Notably, Kaos, Yangs Wus (2009) studies point out that, on the one hand, the Chinese government tightly controlled the IPO process with regulations, and on the other hand, the poor and incomplete regulations with the ineffective monitoring provided opportunities for managers to manipulate earnings to maximize the proceeds from the IPO. It is worth noticing that The China Securities Regulatory Commission (CSRC) does not price IPO only, but also times it. As a consequence, it is very important and meaningful to have a look at the government behavior in the Chinese IPO markets as well as whether or not the governmental regulations relate to IPO underpricing. The Chinese regulation authority primarily concentr ates their attention to three items: first, CSRC not only restricts the issuing prices of IPOs, but also limits the amount of supply (Tian, 2003), issuing size is an main proxy for the supply, which means the total supply of IPO shares is periodically fixed and the offering size of new offerings is controlled by CSRC; second, on the grounds of Tians (2003) study about the issuing size restriction of IPOs, it cannot be ensured for each investors in the primary market to get the shares which they subscribe, therefore the subscription rate is regulated by state in China; Last, in the early stages of the markets development the CSRC decide by pre-set IPO P/E ratio which is staple to determine and calculate IPO issue price (CHEUNG, OUYANG, TAN, 2009). Empirically, based on explorative samples of 343 from Shenzhen and 393 from Shanghai Stock exchange from 1992 to 1998, Lau (2004) finds that the regulation and Company Law of CSRC try to investment and obtain benefit for the government, as well as to protect the interests of the State; CSRC control the P/E ratio for each new issue, industrial standards, and the IPO quotas. Therefore he presents that the new issue was usually underpriced and sold to individuals of entities related to the company at the early stage of construction of listed companies due to governmental financial controlling. Furthermore, Jones et al. (1999) chose a sample of 630 share issue privatizations (SIPs) from 59 countries, including developed, developing, and transitional countries during the period 1977-1997, and discover that governments consistently underpriced IPOs. 2.6 Performance and firm control Previous literatures frequently use these profitability, operational, or financial variables (e.g. Morck et al., 1988; McConnell Servaes,1995; Choi et al., 2007). With regard to asymmetric information, the pre-listing status of organizational operation is always concerned on, primarily referring to firm size and profitability. For example, Beatty Ritter (1986) also proposed that the firm size is associated with information that a larger-sized firm is better known than a smaller-sized firm. Consistently, such as Morck et al. (1988); McConnell Servaes (1990), they concludes that larger firms tend to have better performance relative to small firms. In addition, certain finance literature uses return on assets as a profitability measure because empirical evidence reveals a positive association between return on assets and firm performance. However, it does not have significant relationship with firm performance in Korea based on Choi et al. (2007). The total debts to total assets ratio measures a firms financial risk. Morck et al. (1998) expect that there is a negative relationship between the total debts to total assets ratio and firm performance. The log of total assets is a proxy for firm size, which is concluded by Choi et al. (2007) showing that a negative relationship with firm performance. And Morck et al. (1988) replenish Choi et al. is work and indicate that the negative relationship is insignificant. 2.7 Board characteristics In recent years the nature of the relationships among board size, board composition and firm performance, IPO performance has a growing number of scrutiny. Plenty of scholars emphasize the importance of the monitoring role played by independent outside directors, such as Byrd Hickman (1992); Choi et al. (2007). 2.71 The impact of board size on IPO underpricing and firm performance Some empirical evidence from the US stock market research exclusively, such as, Yermack (1996) assesses the impact of board size on firm value and finds an inverse relation between firm value and the total number of directors, which is based on an empirical evidence for a sample of large US industrial corporations between 1984 and 1991. And Yermack (1996) shows a further work that financial measures, such as return on assets and return on sales, are negatively associated with the size of corporate board members. By contrast, Dalton et al. (1999), which presents the meta-analysis in his research and draws on the results from a mass number of previous US studies; ultimately he suggests a positive relationship between board size and firm performance. It is explicit to collect information from these contrasting reporting that both advantages and disadvantages exist for the larger number of board members. From an international perspective, Conyon Peck (1998) find there is a negative correlation between equity turnover and board size for a sample of European firms, even though their results with respect to market-based measures of performance are less clear-cut. More recently, de Andres et al. (2005) also point out an agreed report that there is a negative relationship between firm value and board size (controlling for a number of additional factors) in 10 OECD countries. Taken as a whole, Jensen (1993) argues that the benefits deriving from larger boards are outweighed by the incremental costs of the potentially poorer communication and decision-making processes associated with larger groups, which is consistent with these international based results. 2.72 The impact of board composition on IPO underpricing and firm performance With regard to the impact of board structure on IPO underpricing and firm performance, Certo et al. (2001) address the relationship between board composition and IPO underpricing. In the study of OConnell Cramer (2010), among a sample of firms representing a broad array of industries, they find that board prestige, that measured as other directorships held by board members, is negatively associated with IPO underpricing. However, there exists many reports are inconsistent with their hypotheses, showing that the proportion of independent outside directors, that denoted board vigilance, is not negatively associated with IPO underpricing. As Stiles Taylor (2001) propose that a higher proportion of independent outside directors should be in relation to stronger financial performance. Furthermore, from a strategic perspective recent work by Yawson (2006), he also states that when facing performance declines, firms with a higher proportion of outside directors are more likely to san ction staff layoffs. Nonetheless, not withstanding these findings, there is a relative dearth of empirical evidence pointing to a significant positive association between firm performance and board independence. For instance, Hermalin Weisbach (1991) present their findings from the US stock market that there is no relation between the proportion of non-executive outside directors and IPO firm performance; Vafeas Theodorou (1998) and Dulewicz Herbert (2004) synchronously provide similar results for the UK. Another recent work by de Andres et al. (2005) also fails to build a statistically significant relationship between firm performance and board composition across a sample of OECD countries. Interestingly, Agarwal Knoeber (1996) and Klein (1998) report that the US boards may in fact have an excessive proportion of non-executive directors. Besides, many academics and commentators have paid much more attention to the exact percentage of non-executive directors on corporate b oards. Such as, Dulewicz Herbert (2004) question the validity of the notion that a board should be comprised of at least 50% non-executives. However, empirically the evidence reveals that firms with a higher proportion of outside directors have a smaller likelihood of experiencing financial distress (Elloumi Gueyie, 2001). Moreover Daily et al (2003) extend Elloumis Gueyies work and argue that financially distressed firms with independent boards have a lower incidence of bankruptcy filings.